CPI

Some Uses of the CPI
The CPI is often used to adjust consumer income payments for changes in the dollar's value and to adjust other economic series. Social Security ties the CPI to income eligibility levels; the federal income tax structure relies on the CPI to make adjustments that avoid inflation-induced increases in tax rates and finally, employers use the CPI to make wage adjustments that keep up with the cost of living. Data series on retail sales, hourly and weekly earnings and the national income and product accounts are all tied to the CPI to translate the related indexes into inflation-free terms.



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The CPI and the Markets Movements in the prices of goods and services most directly affect fixed-income securities. If prices are rising, fixed bond payments are worthless, effectively lowering the bonds' yields. Inflation also poses a serious problem to holders of fixed annuities and pension plans, as it erodes the effective value of the fixed payments. Many retirees have watched their pension payment amounts lose buying power over time.

Price volatility can be bad for equities as well. Modest and steady inflation is to be expected in a growing economy, but if the prices of resources used in the production of goods rise quickly, manufacturers may experience profit declines. On the other hand, deflation can be a negative sign indicating a decline in consumer demand. In this situation, manufacturers are forced to drop prices to sell their products, but the resources and commodities used in production may not fall by an equivalent amount. Again, the companies' margins are squeezed due to the stickiness of prices for some items and the elasticity of prices for other items.

Protecting Against Inflation Fortunately, as the financial markets have become more sophisticated over time, investment products have been created to help even the average person hedge inflation risk. Mutual funds, or banks, concerned about rising inflation might purchase special inflation protected bonds known as TIPS. (You can read more on TIPS in Inflation Protected Securities - The Missing Link.) Furthermore, the Chicago Mercantile Exchange offers futures contracts on the CPI, which can be used to hedge inflation. These contracts also provide useful information about the market consensus for prices in the future.


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Definition of 'Consumer Price Index - CPI'

A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.


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